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In what follows, we will assume that the subsidiary or project cashflows have been restated in dollars. Hence the issue is coming up with a discount rate that is appropriate for dollar flows.

In principle, the cost of capital used should be a forward-looking rate. However, in practice, the components of the cost of capital are often estimated using historical data.

While this is unavoidable, historical estimates should be used with care.

An alternative method is to use the Adjusted Net Present Value approach, where the project is valued as a stand-alone all equity project and impact of the the different financing frictions are added to this base value.

Foreign projects in non-synchronous economies should be less correlated with domestic markets.

Paradox: LDCs have greater political risk but offer higher probability of diversification benefits.

Where there are barriers to international portfolio diversification, corporate international diversification can be beneficial to shareholders.

Studies have shown that international index movements explain returns on domestic companies, after accounting for the domestic component of US indexes. This suggests that there is a significant benefit from the ability of multinational corporations to invest abroad.

In order to estimate a beta for the foreign subsidiary, a history of returns is required. Often this is not available. Hence, a proxy may have to be used, for which such information is available.

Should corporate proxies be local companies or US companies?

The beta is the estimated slope coefficient from a regression of the stock returns against a base portfolio, which is the global market portfolio, according to the CAPM. However, this assumes that markets are integrated.

In practice, is the relevant base portfolio against which proxy betas are to be estimated, the US market portfolio, the local portfolio, or the world market portfolio?

Should the market risk premium be based on the US market or the local market or the world market?

If we assume that the multinational in question is a US multinational with investors who are globally diversified, then, in principle, the beta of the foreign subsidiary should be estimated with respect to a global market portfolio, and a global market risk premium should be used.

Furthermore, if cashflows are measured in dollars, the right risk-free rate to be used is also the US Treasury rate.

If foreign proxies in the same industry are not available (say because of data issues), then a proxy industry in the local market can be used, whose beta is expected to be similar to the beta of the project’s US industry.

Alternatively, compute the beta for a proxy US industry and multiply it by the unlevered beta of the foreign country relative to the US. This will be valid, if:

The US beta for the industry is the same as that of that industry in the foreign market as well, and

The only correlation, with the US market, of a foreign company in the project’s industry is through its correlation with the local market and the local market’s correlation with the US market.

The previous approaches that use US base portfolios and/or US proxies effectively ignore country risk, assuming that it is diversifiable. However, this may not be the case. In fact, with globalization, cross-market correlations have increased, leading to less diversifiability for country risk.

Furthermore, it may not be enough to look at the beta alone of a foreign project's beta, because this only deals with contribution to volatility.

Skewness or catastrophic risk may be significant in the case of emerging markets. The impact of a project on the negative skewness of the equityholder's portfolio could be significant and should be taken into account.

For example, India's beta could be negative, but it would not be appropriate to discount Indian projects at less than the US risk-free rate.

If investors do not like negative skewness (i.e. the likelihood of catastrophic negative returns), we should augment the CAPM with a skewness term.

An alternative would be to estimate a country risk premium based on the riskiness of the country relative to a maturity market like the US, and to incorporate this into the cost of equity of the project.

Country Premiums may be estimated by looking at the rating assigned to a country’s dollar-denominated sovereign debt.

One can then look at the spread over US Treasuries or a long-term eurodollar rate for countries with such ratings (sovereign risk premium). This spread would be a measure of the country risk premium.

One could also look at the spread for US firms’ debt with comparable ratings.

Optionally, one might then adjust this spread by the ratio of the standard deviation of equity returns in that country to the standard deviation of bond returns – to convert a bond premium to an equity premium.

The country risk premium that is obtained can then be used in two ways:

One, it could be added to the cost of equity of the project. This assumes that the country risk premium applies fully to all projects in that country

Two, one could assume that the exposure of a project to the country risk is proportional to its beta. In this case, one would add the country risk premium to the US market risk premium to get an overall risk premium. This would then be multiplied by the beta as before to obtain the project-specific risk premium.

If we believe that country risk is not diversifiable and/or is not otherwise captured in the beta computation or that it captures other kinds of risk that go beyond variability risk, we need to adjust for country risk.

Add sovereign risk premium to the required rate of return:(If we are worrying about country risk premiums, we’re probably discounting the existence of a single international asset pricing model, since it implies an integrated world; strictly speaking, we could still hold that an international asset pricing model holds, but it is not a mean-variance model. We will ignore this here.)

IBM is considering having its German affiliate issue a 10-year $100m. Bond denominated in euros and priced to yield 7.5%. Alternatively, IBM’s German unit can issue a dollar-denominated bond of the same size and maturity and carrying an interest rate of 6.7%.

If the euro is forecast to depreciate by 1.7% annually, what is the expected dollar cost of the euro-denominated bond? How does this compare to the cost of the dollar bond?

The pre-tax $ cost of borrowing in euros at a interest rate of rL, if the euro is expected to depreciate against the dollar at an annual rate of c, is rL(1 + c) + c. There is a “depreciation penalty applied to the interest (first term) and to the principal (second term).

In this case, we get an expected $ cost of borrowing euros of 7.5(1-0.017)-1.7 or 5.67. This is below the 6.7% cost of borrowing $s.

If the German unit is taxed at ta, the ta, is r = rL(1+c)(1‑ta) + c. Thus, if ta = 35%, r = 7.5(1-0.017)(1-0.35) - 0.017, or 4.78%.

Borrowing in the local currency can help reduce foreign exchange exposure. This may reduce the volatility or beta risk of the cashflows expressed in dollars. It should, in any case, reduce bankruptcy risk.

Borrowing globally may be cheaper from a tax point of view; local government subsidies may be available, too.

Lending money to a subsidiary might mean easier repatriation of profits to the parent than structuring the investment in the subsidiary as equity.

Raising funds locally can be useful if there is political risk. In case of expropriation, the parent can default on loans by local banks to the subsidiary.

If funds can be raised in the foreign market with payment to be made with local cashflows alone and no recourse to the parent, this could reduce the likelihood of expropriation, as well.